Analysts get bullish on Japan

Legislative stalemate looms with Abe's resignation, but it may not be all bad

By

ChrisOliver

HONG KONG (MarketWatch) -- Fund managers and equity strategists are squaring off for a sumo-style tussle in the wake of Shinzo Abe's resignation as Japan's prime minister last week.

Most agree legislative stalemate looms between Japan's two dominant political parties, but what it all means for the equity market remains, much like the traditional autumn wrestling tournament underway in Tokyo this month, up for grabs.

Some analysts expect the likely delay of fiscal reforms, due to the turmoil, to provide a short-term boost for stocks, though others worry it could undermine Japan's international competitiveness in the longer run.

Akio Yoshino, chief economist for Societe Generale Asset Management in Tokyo, says one reason for optimism is economic reforms considered hallmarks of the Abe administration and the ruling Liberal Democratic Party will probably move to the backburner.

While that might not be the best thing for the economy in the long run, it should assist stock prices in the short term, he says.

"It's very nice for the Tokyo equity market to have political tension between the ruling party and the opposition party," said Akio Yoshino, chief economist for Societe Generale Asset Management in Tokyo. See more global markets coverage.

Yoshino says legislative gridlock should push back key Koizumi-Abe corporate reforms such as privatizing the post office, boosting consumption taxes, corporate tax reform and fiscal consolidation. And if the LDP's old guard slips back in, expect higher public spending and a falling yen.

One winner could be large manufacturing companies, a group that makes up more than half the companies on the Tokyo Stock Exchange. A falling yen makes Japanese goods more competitive overseas.

Another beneficiary could be domestic companies, including engineering and construction-related firms. In place of economic reforms, analysts expect fiscal policy that bears more resemblance to the "bridges-to-nowhere" public works programs of the 1990's, as the two parties spar for the hearts of voters in Japan's key rural communities. "These measures should boost corporate earnings," Yoshino said.

Largely insulated from credit woes

Japanese share indexes have so far lagged other regional Asian markets in rebounding from the August lows, when problems in U.S. structured credit roiled global markets.

On Friday, the 225-issue Nikkei (1804610) climbed 1.9% to 16,127.42. Since touching a high of 18,240.3 on July 20 in the weeks before global markets tumbled, the index is down 11.2%. Between July 20 and Friday in Hong Kong, the Hang Seng Index has risen 6.9%, while South Korea's Kospi and Taiwan's weighted Price are both down 5.7%.

The weakness may have little to do with fundaments. Japan's economy and its banks are largely insulated from problems in the U.S. housing market, analysts say. However, they may be vulnerable to rising risk aversion, at least in the short term. Foreign investors account for about 30% of holdings on the Tokyo Stock Exchange, but about 60% of trading, and are prone to pull up stakes at signs of trouble.

"Investors are shrinking equity exposure globally and that is really coming back to Japan," said Yoji Takeda, who oversees $900 million in assets for RBC Investment Management Asia.

Takeda says the market downdraft in recent weeks has left shares of some companies at value levels. He particularly likes real estate companies such as Mitsui Fudosan (8801) and Mitsubishi Estate (8802), which are near their level from two years ago.

"Real estate prices are going up and rents are going up, so these look pretty cheap right now," Takeda said.

Banking shares, he says, are another good bet. Mitsubishi UFJ Financial Group (8306) and Mizuho Financial Group (8411) rank as two favorites.

Both have seen their share prices decline sharply in recent weeks despite reporting little exposure to woes afflicting the U.S. subprime mortgages. Delays in interest-rates increases by the Bank of Japan will keep loan margins under pressure, but Takeda says the banks should be propped up by higher earnings from non-interest income.

"These look pretty cheap right now, their capital ratio is strong, their earnings power is up," he said.

Some downside seen

Others say caution is warranted.

Glenn Maguire, Asia Pacific chief economist for Societe Generale in Hong Kong, believes increased public spending in regional areas of Japan, or "pork-barrel politics," would be paid for by delays in cutting corporate taxes.

"The medium-term outlook is for a loss in Japan's regional and international competitiveness," Maguire said. Additional spending of 2 trillion yen ($17.4 billion) to 3 trillion yen will be approved through supplemental budgets this autumn, he says. He added tax reform is more likely to focus on increasing the 5% national sales tax, known as the consumption tax.

If the Bank of Japan raises rates early next year, the outcome could be similar to the policies that failed to lift the economy out of its post-bubble malaise. Maguire said the BOJ is likely to keep rates on hold for the remainder of this year, but hikes could be back on the cards early next year with Governor Toshihiko Fukui inclined to normalize monetary policy before his tenure expires.

"Japanese policy makers are blithely repeating the exact policy errors of the late 1990s, when the consumption tax was prematurely raised, and of 2000, when the zero-percent interest rate policy was overturned and monetary policy tightened," Maguire said.

On the plus side, Japan's economy has yet to undergo much of the credit leveraging that has underpinned growth in many Western countries. Japan's broad money supply has risen 8% in the last five years, compared to 46% in Europe and 31% in the U.S.

Economy still on solid ground

It's unlikely any changes in leadership will significantly derail, at least in the short run, an economy that has averaged 2% growth since 2003.

The Japanese economy contracted 1.2% in the second quarter, but economists say this was mostly a hiccup. They expect gross domestic product to expand 2.2% this year and 2.3% in 2008. The job markets remain tight; national unemployment fell to a 10-year low in July.

Analysts said weaker industrial production in July reflected an inventory drawdown and the effects of a mid-month earthquake in Niigata Prefecture that cut production of automotive parts and created shutdowns at Toyota
TM, +0.38%
and other factories.

Societe Generale's Yoshino says foreign exchange markets are likely to express disappointment over the demise of structural reforms, sending the yen to the 120-level against the U.S. dollar by the end of the year. A weaker yen would boost the bottom line of export-oriented companies such as Canon Inc. (7751) and Toyota Motor Corp. (7203).

Yoshino forecasts the Nikkei 225 average (1804610) will touch 18,000 by year-end, revised down from an earlier forecast of 18,500 before Abe tendered his resignation. He said the revision reflected the dashed hopes of reform-minded foreign investors.

Stock prices are currently pricing in a 10% decline in recurring corporate profit growth this year. Corporate profits are on the rise, resulting in a mismatch that has left the Nikkei undervalued by some measures.

Trading at a forward price earnings of 15, the Nikkei was valued "at one of the lowest levels for the last 30 to 40 years," said Masanaga Kono, an equity strategist with Societe Generale Asset Management in Tokyo.

Clues to the direction of Japanese stocks could be found in the broader Tokyo Stock Price Index, or Topix, which provides a weighted average of listed stocks on the Tokyo Stock Exchange.

RBC's Takeda says he's watching the gauge for signs it's ready to break above technical resistance at the 1,750-point level, or about 15% above its current level of 1,544.71.

There have been six failed attempts to break above that level in the last 15 years. The most recent failure occurred in March. Takeda says he was disheartened by the breakdown, but says the index is likely to nudge that level again within 12 months.

"Fundamentals for Japanese corporations are better than ever," Takeda said, adding he's a bull on Japan on one condition -- the world economy doesn't fall into recession.

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